IMF: “Deutsche Bank appears to the most important net contributor to systemic risks in the global banking system”

One of the lessons of 2008 is the fact that governments need to be more aware of the operations of banks and to understand that bank failures can have a catastrophic effect on national economies. Notwithstanding this, there is good reason for apportioning a share of responsibility for the events of 2008 to the behaviour of some banks, and fines are still being imposed on international banks, including Deutsche Bank. In September 2016 the U.S. Department of Justice raised the prospect that Deutsche Bank could be fined $14 billion in relation to mis-sold mortgage-backed securities.[1] Reuters noted that, “Deutsche was once one of Europe’s most successful players on Wall Street. Like many of its peers, it has since faced a slew of lawsuits that often trace back to the boom years before the crash. Its litigation bill since 2012 has already hit more than 12 billion euros.”[2]

Deutsche is an interesting bank, because its central position in the German economy and its heavy involvement in the U.S. derivatives market in 2008, means that it is still dealing with the consequences of the Great Recession, and its position has been seriously weakened as a result; its problems also illustrate the risks that the global banking system still faces. The IMF concluded that the position of Deutsche Bank was such that it was not only a problem to the German economy, but because of the inevitable knock on effects on the EuroZone of any failure, that, “Deutsche Bank appears to the most important net contributor to systemic risks in the global banking system, followed by HSBC and Credit Suisse.”[3]

Deutsche Bank AG is the Achilles Heel of the German economy. According to John Kay, both JP Morgan and Deutsche Bank, hold about 20% of the total global derivatives exposure, in other words each has around $50 trillion in derivatives. The market capitalization of JP Morgan was $239bn on the 26 August 2016. In contrast, Deutsche’s capital value was $16.8 bn. on the 28th September 2016,[4] down from its January 2014 high of $58.28 bn.[5] According to the BIS the size of the Global OTC derivatives markets was $493 trillion at the end of 2015, a reduction, but still an enormous potential liability. In comparison, the World Bank estimated the entire global economy (GWP) as worth $78 trillion in 2015, so the derivatives market is worth nearly 6½ times GWP.

It is not sufficient to claim that because Deutsche’s derivatives holdings are nearly 3,000 times its capital value that the bank cannot possibly survive; certainly there must be serious questions as to whether it can overcome this massive overhang of risk. This is Deutsche’s “bumblebee” problem; it used to be thought (incorrectly) that the weight of the bumblebee and its small wings meant that it should not be able to fly. The global financial system is so complex and interlinked that it is impossible for an outsider to know what part of Deutsche’s derivatives book is toxic, and to what extent this undermines the bank’s solvency. However, the rapid decline in Deutsche Bank capitalization in the period 2014-2016 indicated that markets were very nervous about the bank’s potential exposures, including its extremely large derivatives book. The likely outcome for the bank will probably be some form of nationalization, or German government rescue; which will have profound ramifications in the EuroZone. It is also worth remembering that German’s GDP, which was $3.356 trillion in 2015 (World Bank figures), is less than Deutsche’s $50 trillion derivatives book.

Of course Deutsche’s situation has not been helped by negative interest rates from the European Central Bank (ECB), or the decline in German exports.[6] But Deutsche Bank’s weakening position, signalled by its falling share price, was essentially the result of decisions made over a number of years, ECB policy merely made things more difficult, but has not been a prime cause of the bank’s difficulties. Although Deutsche’s CEO, John Cryan, told the German newspaper Handelsblatt, “Monetary policy is thwarting goals to strengthen the economy and to make banks safer by now.” He warned of “fatal consequences” that could occur should the European Central Bank continue down the road of negative rates. Because the ECB held its deposit rate at -0.4 percent; government debt yields in large parts of Europe also carried negative rates. Fitch Ratings calculated that in August 2016 $11.4 trillion in global sovereign debt was carrying negative yields.[7]

The weakness of Deutsche Bank matters to the German economy because the bank is highly connected within that country’s financial and industrial organizations. The IMF referred to this in June 2016 when it noted that, “The largest German banks and insurance companies are highly interconnected. The highest degree of interconnectedness can be found between Allianz, Munich Re, Hannover Re, Deutsche Bank, Commerzbank and Aareal Bank.”[8] The problems at other German banks, such as Commerzbank and Bremen Landesbank, make the reluctance of the German authorities to write-off bad debts to Greece, and other Mediterranean EuroZone countries, understandable. Apart from non-performing Mediterranean debt, German banks also carry $100 billion of shipping debt (25% of the global total), at a time when the shipping industry is losing large amounts of money, a sizeable percentage of these debts are also likely to be non-performing. Deutsche is exposed to shipping losses in addition to its other problems.[9] The CEO of Credit Suisse went so far as to question whether European banks “still had a viable business model”. Tidjane Thiam told a Bloomberg conference in September 2016 that, “Concerns about rock-bottom interest rates and how much capital banks should hold meant returns to investors were too low, making banks ‘not really investable’”.[10]